SAVE   |   EMAIL   |   PRINT   |   RSS  
Cashing out
I just left work to go to graduate school. Should I cash out my 401(k) or roll it into something?
July 8, 2005: 2:09 PM EDT
By Walter Updegrave, CNN/Money contributing columnist

Sign up for the Ask the Expert e-mail newsletter
More information on Updegrave's new book.

NEW YORK (CNN/Money) - I'm 24 and recently left work to go to graduate school. I have about $3,000 in my 401(k) and am wondering whether to just take the cash or roll it into an IRA Rollover or even a Roth. What do you think I should do?

-- Kevin Hay, Birmingham, Alabama

I know that getting your hands on that three grand seems pretty tempting at this time in your life. But if there's any way you can get by without tapping into your little stash, I'd definitely recommend at least doing the IRA rollover, and possibly going a step farther with the Roth.

This way, instead of having some extra spending money (which will be less than $3,000, by the way, since you'll pay taxes plus a 10 percent premature withdrawal penalty), you'll still have a nest egg growing in value until you need it in retirement.

And, in fact, a recent change in the law concerning employers' obligations when it comes to the 401(k) funds of departing workers will make it easier for you to follow my advice.

Previously, if you left a company and your 401(k) account balance was $5,000 or less, your employer was allowed to cash out the account and give you the money without obtaining your consent. The only way your money was rolled over into an IRA account or a new employer's 401(k) plan was if you specifically requested it.

Not surprisingly, relatively few workers made this request, either because they wanted the cash or they just weren't aware of their options. Eager to avoid the costs of maintaining these small accounts, employers were only too glad to just cash people out.

As a result, nearly 90 percent of the 401(k) balances under $5,000 of departing employees were cashed out. Although these employees would still have the opportunity of rolling over the money into an IRA, I suspect that once they got hold of that money, most of them spent it.

As of March 28, however, if you leave your job and your 401(k) account balance is between $1,000 and $5,000, the employer must roll over your account balance into an IRA, unless you specifically elect to take the cash or have the money transferred to a new employer's plan. So, in other words, if you do nothing, your employer should roll the money over into an IRA rollover account for you.

Don't just do nothing

But I don't recommend you just do nothing. Why? Well, if your employer does the rollover without input from you, your money will be put into an investment geared toward preservation of principal, most likely a money market fund.

But at your age, you're more interested in growing your account balance. Which means you want the bulk of your nest egg invested in stocks or stock funds, with perhaps a bit in bonds to provide some stability.

There are many ways to achieve this goal. You can go to our Asset Allocation tool to find out how much of your money should go into stock funds vs. bond funds and from there go to our Fund Screener to choose specific funds to create your portfolio.

Or you can go a simpler route: invest your money in a target date retirement, also known as a lifecycle fund. With this option, your money is automatically divvied up into a blend of stock and bond funds appropriate for your age, and your mix automatically morphs away from stocks to bonds over time so you're more conservatively invested as you approach retirement.

I think this no-muss-no-fuss approach is great for people who aren't into the nitty-gritty details of investing either because they just don't like it or because they have other things on their mind, like grad school.

Don't touch the money on the way past

Once you've chosen a fund, explain to the fund company that you want to do a trustee-to-trustee transfer of the money from your old 401(k) into an IRA rollover. Someone at the fund company should be able to provide the paperwork you need and walk you through the process.

You should also contact someone at your previous employer's personnel department or in your old 401(k) plan's administration department and let them know of your plans so they don't proceed on the rollover without you. (If they've already rolled the money over, not to worry: you can roll it again to where you want it.)

Now to the Roth IRA issue. You can't roll your money directly from a 401(k) into a Roth. You've got to go to an IRA rollover first. Once you've done that, though, you do have the option of establishing a Roth, assuming you meet the income eligibility requirements, which won't be a problem in your case.

But to transfer your money from an IRA rollover to a Roth, you'll have to pay tax (but not the 10 percent early withdrawal penalty) on the amount of money in the IRA.

That may seem like a drag, but remember, not only will your money grow free of taxes in the Roth as in the rollover IRA, but your withdrawals will be tax-free as well. (Your withdrawals from the rollover IRA are taxed because you didn't pay tax on that money when you originally put it in your 401(k).)

Taxes now or later?

So the question is, are you better off paying taxes on your IRA rollover balance now so you can pull out your money tax-free down the road? Or are you better off avoiding the tax bill today, letting your money grow free of taxes and then paying the tax when you withdraw it in retirement?

Generally, you're better off paying the tax tab today and doing the Roth if you think you'll be in a higher tax bracket when you pull the money out. That's because you'll be paying tax at a lower rate and avoiding the tax when you face a higher rate.

Unfortunately, we can't predict what tax rate we'll face in the future, in part because we're not certain what our income will be in the future and also because Congress has been know to change tax rates from time to time.

That said, though, I think it's a pretty good bet that someone like you who makes little money now but is improving his earnings prospects by going to grad school is much more likely to end up in a higher tax bracket in retirement than today. Besides, there are other advantages to the Roth, one being that you're not required to make mandatory withdrawals starting at age 70 1/2, as you are with an IRA rollover. Which means you can let those tax-free gains compound for the rest of your life if you want, and even pass the account on to your heirs.

To sum up, then: don't take the cash and run. Roll the money into an IRA rollover and, if you can come up with the cash to pay the tax bill, roll it over again to a Roth IRA.

But whether you stay in the IRA rollover or go with the Roth, remember to invest your stash for long-term growth, either by choosing individual stock and bond mutual funds or, if you want to go the simpler route, by investing in a target retirement fund.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."  Top of page


Ask the Expert
Mutual Funds
Manage alerts | What is this?